When we wrote “The euro is naked” on February 11 we were certainly bearish, but did not expect the euro to dictate all markets behavior even at high frequency. Watching the markets these days, it is fairly clear that the FX rate EUR/USD has become the barometer for the success of the euro bailout. We believe this is a mistake.

We see the financial package announced two weekends ago as designed to buy time to reform the institutions that make the euro. That effort is designed to save the credibility of the euro, but sacrifices the short-term value of the currency vis-à-vis other currencies. Thus, looking at the depreciation of the euro as a signal that EU efforts are not working is a mistake.

The trend of euro depreciation is only slower now that the EU has decided to provide a backstop for the most challenged fiscal positions in the area. The credibility (thus, the medium-term value) of the euro would recover once a real debate about the institutions that underly the currency union is under way, towards tighter fiscal rules, with effective enforcement and a mechanism for non-compliant countries to be suspended/expelled. Anything short of this amounts to buying time, as it does not address the fundamental problem of the currency union. Persistent differences in productivity growth that lead to serious competitive losses in some countries is usually associated (but not necessarily so) with the fiscal problem. It also requires an exit mechanism, but such problem without the fiscal problem does not necessarily threaten the union.

The size of the financial backstop announced 10 days ago is significant and it should buy enough time for such reforms to be designed and discussed. At the same time, some of the decisions within that financial backstop damaged euro institutions for the medium-term (ECB independence, EU constitution), exacerbating the need for reform.

In terms of markets, we expect the euro to remain under pressure (depreciate towards 1.1 in terms of EUR/USD), as the reform debate will take time to materialize. But we see the EU backstop package as enough to allow for fiscal and labor reform to occur in the countries most challenged (still think Greece will restructure its debt, potentially exit the euro area). All this means that the withdrawal of monetary stimuli by G7 central banks is now less likely, and capital is bound to continue to be reallocated to US markets. The more structural reallocation to the best non-G7 and EM countries is happening, but will take time to actually reduce the volatility in some of those markets (still perceived as ‘higher risk’).

The risk to this view is a deeper recession in Europe, making the fiscal reform troublesome, which would mean a more serious depreciation of the euro and credit issues. We do not exaggerate the connection between fiscal reform/adjustment and recession, especially in countries with fiscal credibility issues. The measures recently announced by Spain do help that country recover credibility and could be understood as conducive to growth (especially if joined by labor reform).